Comparing Formal and Informal Financial Sectors
INFORMAL FINANCIAL SECTOR FORMAL FINANCIAL SECTOR
1. The informal financial sector provides 1. Formal financial institutions ignore small
savings and credit facilities for small farmers, lower-income households, and small-
farmers in rural areas, and for lower- scale enterprises in favour of a larger-scale,
income households and small-scale well-off, and literate clientele which can
enterprises in urban areas. satisfy their stringent loan conditions.
2. The procedures of informal schemes are 2. Complex administrative procedures are beyond
usually simple and straightforward; as the understanding of the rural masses and small
they emanate from local cultures and savers.
customs, they are easily understood by
the population.
3. The informal sector mobilises rural 3. Formal financial institutions do not mobilize
savings and small savings from low-income rural savings or small-scale deposits. Commercial
urban househods. banks could contribute to rural and small savings
mobilization if they had adequate branch networks
and if they adopted the relevant procedures.
4. Informal groups operate at times and on 4. The working days and opening hours of formal
days which are convenient for their financial institutions do not take rural work
members. schedules into account;banks are oopen at times when
farmers are at work in their feilds.
5. Informal sector associations accept any 5. Formal sector institutions are selective regarding
amount of regular savings, even the most clientele, so as to avoid having clients who make
modest sums which a saver can aford to set only small deposits. Their financial technology is
aside. The financial techniques on which not suited to the management of modest sums from a
such informal groups are based lend large number of savers.
themselves to the management of a large
number of small accounts.
6. Access to credit is simple, non- 6. Loan application procedures are complex and require
bureaucratic, and little based on reading and writing skills so that a file on the
writtern documents. Literacy is not borrower may be established.
a requisite.
7. The simple and direct processing of loan 7. Processing of loan requests is complex, resulting in
requests allows for their prompt approval long delays before final approval or rejection. Even
and a minimum delay in disbursement. when approval is obtained, loan delivery is slow.
Rejections are rare; but the level of
risk is reflected in the interest rate
charged.
8. Collateral requirements on loans are 8. Collateral requirements correspond to the situation of
to local conditions and borrowers relatively well-off urban-dwellers: deposits or
capacity. The conditions may be based savings accounts in a commercial bank, property which
either on regular contributions to ROSCAs can be mortgaged.
or on precise knowledge of farm size and/or
crops harvested so as to determine the
borrower's capacity to repay a loan.
9. Transaction costs are low 9. Transaction costs are high
10. Repayment rates rates are high 10. Repayment rates are low.
11. Because they emanate from local 11. Formal sector institutions do not have close contact
environment, informal groups are aware with the environment in whic they operate. Sometimes
of the problems that members may be they prosecute defaulters, which can have negative
confronted with, and therefore they social repercussions, while at other times they do
can deal with repayment difficulties not sue for reimbursement, leading borrowers to belive
in a pragmatic manner. Debt rescheduling that formal loans are free.
is possible.
12. The informal sector has a dense and 12. Unfamiliar with the grass-roots environment, formal
effective information network at the institutions are ill-served by a mediocre supervisory
grassroots level for close supervision and monitoring network, and are unable to gain insight
and monitoring of borrower activity - into the activities of their clientele.
particularly their cash flow - whether
they are members of an informal association
or not. This contributes to the efficient
mobilization of savings and ensures high
loan repayment rates.
13. Within the informal sector, information is 13. Formal sector institutions do not have a good network
widely diffused. The regular meetings of for dissemination of information. In addition, they are
informal savings and credit associations out of touch with the rural masses and make little
serve as a forum for dissemination of to seek ways of reaching them.
information.
14. The interest paid on deposits in the 14. Some institutions of the formal sector do not even
informal sector compares favourably with offer savings facilities. Others apply low - or
that paid in the formal sector, thus sometimes even negative - real interest rates, thus
providing an incentive fo rural and small putting off many a potential saver.
urban households to save.
15. The informal sector charges competitive 15. Public institutions charge very low - sometimes
lending rates; though they are sometimes negative - real interest rates on loans. Commercial
high, this reflects the scarcity of banks apply moderate lending rates which are nonetheless
loanable funds. There is little connection considerably higher than the interest paid on savings.
between deposit and lending rates. The link between deposit and lending rates is weak.
16. There are no investment opportunities 16. There are investment opportunities for savings which
for savings which have been mobilized have been mobilized but which have not been lent.
but which have not been lent.
17. The informal sector usually does not 17. The formal sector keeps writtern records on the
keep a writtern record on the borrowing activities of clients, although the information
and/or saving activities of its clintele. recorded is sometimes irrelevant.
When it does, the procedures are
relatively simple.
18. The volume and availability of loanable 18. The formal sector regularly has loanable funds
funds are subject to seasonal available.
fluctuations.
19. The informal sector is not subsidized 19. Formal sector institutions are subsidized by the
by the government, nor does it receive government and may also receive grants and other
grants or other forms of support from support from donor agencies.
donor agencies.
20. Savings and credit mechanisms in the 20. A regular supply of funds allows the formal sector
informal sector are not geared towards to lend at any time of the year. This is not the case
accumulating funds befor ethe peak season with government lending institutions, which are deprived
when loan requests are highest. of sufficient funds because of high default rates on
their loans.
21. Despite the widespread dissemination of 21. Formal sector institutions could reach a widely
information within the informal sector, dispersed rural clientele by collaborating with
informal groups are often unaware of new government extesion units. In practice, though,
farming methods, and so members do not they do not resort to such intermediaries and do
learn of new techniques which would allow not provide financial services in rural areas.
them to increase production leels and raise
their standard of living.
- Source:
- Germidis et al. (1991) Financial Systems and Development: What Role for the Formal and Informal Financial Sectors? Paris: OECD Development Centre
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